2010 The Conceptual Framework for Financial Reporting

→ a pillar of IFRS that sets principles for preparation and presentation of F/Ss for external users.

This Conceptual Framework is not an IFRS and hence does not define standards for any particular
measurement or disclosure issue. Nothing in this Conceptual Framework overrides any specific IFRS.

CHAPTER 1: THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING

→ To provide financial information about reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decisions about providing resources to the entity
General purpose financial reports provide information about financial position of a reporting entity,
which is information about entity’s economic resources and claims against reporting entity. Financial
reports also provide information about effects of transactions and other events that change a reporting
entity’s economic resources and claims.
CHAPTER 3: QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION
Information about Economic Phenomena -
Financial reports provide information about reporting entity’s economic resources, claims against
reporting entity and the effects of transactions and other events and conditions that change those
resources and claims.
If financial information is to be useful, it must be Relevant and Faithfully represent what it purports to
represent.
Usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable.
Relevance
Relevant financial information is capable of making a difference in the decisions made by users.
Financial information is capable of making a difference in decisions if it has predictive value,
confirmatory value or both.
Predictive value and confirmatory value of financial information are interrelated.
Materiality
Information is material if omitting it or misstating it could influence decisions that users make on the
basis of financial information about a specific reporting entity.
→ an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to
which the information relates in the context of an individual entity’s financial report.

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Fundamental Qualitative Charateristics Enhancing

Predictive Relevance Comparability like things must look alike and

Confirmatory different things mist look different

Verifiability direct
Faithful Representation indirect
Timeliness
Complete Neutral Free from material error
Understandability

classifying characterizing presenting

information clearly & concisely
Information is reliable when it is complete, neutral and free from error.
Faithful Representation
To be useful, financial information must not only represent relevant phenomena, but it must also
faithfully represent the phenomena that it purports to represent.
To be a perfectly faithful representation, a depiction would have 3 characteristics. It would be complete,
neutral and free from error.
A complete depiction includes all information necessary for a user to understand the phenomenon being
depicted, including all necessary descriptions and explanations.
A neutral depiction is without bias in the selection or presentation of financial information. A neutral
depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the
probability that financial information will be received favourably or unfavourably by users.
Free from error means there are no errors or omissions in the description of the phenomenon, and the
process used to produce the reported information has been selected and applied with no errors in the
process.
If there is no alternative representation that is more faithful, that estimate may provide the best available
information
Applying the fundamental qualitative characteristics
Information must be both relevant and faithfully represented if it is to be useful.
1. Identify an economic phenomenon that has the potential to be useful to users of reporting
entity’s financial information.
2. Identify the type of information about that phenomenon that would be most relevant if it is
available and can be faithfully represented.
3. Determine whether that information is available and can be faithfully represented.
If so, the process of satisfying fundamental qualitative characteristics ends at that point.
If not, the process is repeated with the next most relevant type of information.

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Enhancing Qualitative characteristics
1. Comparability
→ enables users to identify and understand similarities in, and differences among, items.

Consistency refers to use of the same methods for same items, either from period to period within a
reporting entity or in a single period across entities.
Comparability is the goal; consistency helps to achieve that goal.
Comparability is not uniformity. For information to be comparable, like things must look alike and
different things must look different.
2. Verifiability
→ helps assure users that information faithfully represents economic phenomena it purports to
represent.
Verifiability means that different knowledgeable and independent observers could reach consensus,
although not necessarily complete agreement, that a particular depiction is a faithful representation.
Verification can be direct or indirect. It may not be possible to verify some explanations and forward-
looking financial information until a future period, if at all.
3. Timeliness
Timeliness means having information available to decision-makers in time to be capable of influencing
their decisions.
Generally, the older the information is the less useful it is. However, some information may continue to
be timely long after the end of a reporting period because, for example, some users may need to identify
and assess trends.
4. Understandability
Classifying, characterising and presenting information clearly and concisely makes it understandable.
Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyse the information diligently. At times, even well-informed and
diligent users may need to seek the aid of an adviser to understand information about complex economic
phenomena.
Applying the enhancing qualitative characteristics
→ an iterative process that does not follow a prescribed order. Sometimes, one enhancing
qualitative characteristic may have to be diminished to maximise another qualitative
characteristic. For example, a temporary reduction in comparability as a result of prospectively
applying a new financial reporting standard may be worthwhile to improve relevance or faithful
representation in the longer term.
Appropriate disclosures may partially compensate for non-comparability.
→ Enhancing qualitative characteristics should be maximised to the extent possible.

Cost constraint on useful financial reporting

Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting
financial information imposes costs, and it is important that those costs are justified by the benefits of
reporting that information.

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Chapter 4 The 1989 Framework : The Remaining Text
Underlying Assumptions
Going Concern
F/Ss are normally prepared on the assumption that an entity is a going concern and will continue in
operation for the foreseeable future.
Hence, it is assumed that entity has neither the intention nor the need to liquidate or curtail materially the
scale of its operations; if such an intention or need exists, F/Ss may have to be prepared on a different
basis and, if so, the basis used is disclosed.
Accrual Basis
Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting
entity’s economic resources and claims in the periods in which those effects occur, even if the resulting
cash receipts and payments occur in a different period.
This is important because information about a reporting entity’s economic resources and claims and
changes in its economic resources and claims during a period provides a better basis for assessing the
entity’s past and future performance than information solely about cash receipts and payments during that
period.
The Elements of F/Ss
Financial Position Assets, Liabilities, Equity
Financial Performance Income, Expenses
(a) An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.

(b) A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.

(c) Equity is the residual interest in the assets of the entity after deducting all its liabilities.
In assessing whether an item meets definition of A, L or E, attention needs to be given to its underlying
substance and economic reality and not merely its legal form.
Recognition

Income ↑ in economic benefits during accounting period in the form of inflows or

enhancements of assets or
↓ of liabilities that result in increases in EQUITY, other than those relating to
contributions from equity participants.

Expenses ↓ in economic benefits during accounting period in the form of outflows or depletions
of assets or incurrences of liabilities that result in decreases in EQUITY, other than
those relating to distributions to equity participants.

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An item that meets the definition of an element should be recognised if:
(a) it is probable that any future economic benefit associated with the item will flow to or from the
entity; and

(b) the item has a cost or value that can be measured with reliability.

Assets
The future economic benefit embodied in an asset is the potential to contribute, directly or indirectly, to
the flow of cash and cash equivalents to the entity.

The potential may → be a productive one that is part of the operating activities of the entity
→ also take the form of convertibility into cash or cash equivalents or
→ a capability to reduce cash outflows
Future economic benefits embodied in an asset may flow to the entity in a number of ways. For example,
an asset may be:
(a) used singly or in combination with other assets in the production of goods or services to be sold
by the entity;
(b) exchanged for other assets;
(c) used to settle a liability; or
(d) distributed to the owners of the entity.
Many assets, for example, receivables and property, are associated with legal rights, including the right
of ownership.
In determining existence of an asset, the right of ownership is not essential; thus, for example, finance
lease
Although the capacity of an entity to control benefits is usually the result of legal rights, an item may
nonetheless satisfy the definition of an asset even when there is no legal control.
For example, know-how obtained from a development activity may meet the definition of an asset when,
by keeping that know-how secret, an entity controls the benefits that are expected to flow from it.
There is a close association betn incurring expd & generating assets but the two do not necessarily
coincide.

When an entity This may provide evidence that future economic benefits were sought but is not
incurs conclusive proof that an item satisfying the definition of an asset has been
expenditure, obtained

Absence of a does not preclude an item from satisfying the definition of an asset and thus
related becoming a candidate for recognition in the balance sheet; for example, items that
expenditure have been donated to the entity may satisfy the definition of an asset.

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Liabilities
An essential characteristic of a liability is that the entity has a present obligation.
Obligations
» may be legally enforceable as a consequence of a binding contract or statutory requirement.
» also arise, however, from normal business practice, custom and a desire to maintain good
business relations or act in an equitable manner.
If, for example, an entity decides as a matter of policy to rectify faults in its products even when these
become apparent after the warranty period has expired.
Present obligation vs future commitment
Management’s decision of an entity to acquire assets in the future does not, of itself, give rise to a present
obligation.
An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable
agreement to acquire the asset.
In the latter case, the irrevocable nature of the agreement means that the economic consequences of
failing to honour the obligation, for example, because of the existence of a substantial penalty, leave the
entity with little, if any, discretion to avoid the outflow of resources to another party.
Settlement of a present obligation may occur in a number of ways, for example, by:
(a) payment of cash;
(b) transfer of other assets;
(c) provision of services;
(d) replacement of that obligation with another obligation; or
(e) conversion of the obligation to equity.

An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights.
Liabilities result from past transactions or other past events.
An entity may also recognise future rebates based on annual purchases by customers as liabilities
Some liabilities can be measured only by using a substantial degree of estimation. Some entities describe
these liabilities as provisions.
Equity
Equity = Assets - Liabilities
In a corporate entity, funds contributed by shareholders, retained earnings, reserves representing
appropriations of retained earnings and reserves representing capital maintenance adjustments may be
shown separately.
Creation of reserves is required
→ by statute or other law in order to give the entity and its creditors an added measure of protection
from the effects of losses.

→ if national tax law grants exemptions from, or reductions in, taxation liabilities when transfers to
such reserves are made..

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The amount at which Equity is shown in B/s is dependent on measurement of As & Ls.
PERFORMANCE
Profit → a measure of performance or as the basis for other measures, such as ROI or EPS.
I & E → Elements directly related to the measurement of profit.
Recognition and measurement of income and expenses, and hence profit, depends in part on the concepts
of capital and capital maintenance used by the entity in preparing its F/Ss.
Income and expenses may be presented in the income statement in different ways so as to provide
information that is relevant for economic decision-making.
Distinguishing between items of I & E and combining them in different ways also permits several
measures of entity performance to be displayed. These have differing degrees of inclusiveness. For
example, the income statement could display GP, profit or loss from ordinary activities before taxation,
profit or loss from ordinary activities after taxation, and profit or loss.
INCOME
Definition of income encompasses both revenue and gains.

Revenue Gains Unrealised Gains

Revenue arises in the course of
ordinary activities of an entity
and is referred to by a variety of
different names including sales,
fees, interest, dividends, royalties
and rent.
other items that meet the definition of
those arising on the
income and may, or may not, arise inrevaluation of
the course of ordinary activities of an
marketable securities
entity. and those resulting from
increases in the carrying
Gains include, for example, those amount of LT assets.
arising on the disposal of non-CAs.

When gains are recognized in the income statement, they are usually displayed separately because
knowledge of them is useful for the purpose of making economic decisions.
Gains are often reported net of related expenses.
Various kinds of assets may be received or enhanced by income; examples include cash, receivables and
goods and services received in exchange for goods and services supplied.
Income may also result from settlement of liabilities.
For example, an entity may provide goods and services to a lender in settlement of an obligation to repay
an outstanding loan.
EXPENSES
Definition of expenses encompasses losses as well as those expenses that arise in the course of ordinary
activities of the entity

Those expenses arising in ordinary course of Losses Unrealised Losses

business

for example, cost of sales, wages and → those resulting from
depreciation. disasters ( fire and
flood )
They usually take the form of an outflow or → those arising on the
depletion of assets such as cash and cash disposal of non-
those arising from the
effects of increases in the
rate of exchange for a
foreign currency in
respect of the borrowings
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 equivalents, inventory, P,P & E current assets of an entity in that
currency.
When losses are recognised in I/S, they are usually displayed separately because knowledge of them is
useful for the purpose of making economic decisions.
Losses are often reported net of related income.

Recognition of elements of F/Ss

Recognition is the process of incorporating in the balance sheet or income statement an item that meets
the definition of an element and satisfies recognition criteria.
Failure to recognise such items is not rectified by disclosure of accounting policies used nor by
notes or explanatory material.
In assessing whether an item meets these criteria and therefore qualifies for recognition in F/Ss, regard
needs to be given to the materiality considerations.
The interrelationship between the elements - an item that meets the definition and recognition criteria for
a particular element, for example, an asset, automatically requires the recognition of another element, for
example, income or a liability.

Probability of future economic benefit Reliability of measurement

Probability ( used in the recognition criteria )
- degree of uncertainty that the future economic
benefits associated with the item will flow to or
from the entity.
2nd criterion for recognition of an item is that it
possesses a cost or value that can be measured
with reliability.
In many cases, cost or value must be estimated;
Use of reasonable estimates is an essential part of
preparation of F/Ss and does not undermine their
reliability.

Assessments of the degree of uncertainty When, however, a reasonable estimate cannot be

attaching to the flow of future economic benefits
are made on the basis of the evidence available
when F/Ss are prepared.
For example, when it is probable that a receivable
owed to an entity will be paid, it is then
justifiable, in the absence of any evidence to the
contrary, to recognize the receivable as an asset.
made the item is not recognised in B/s or I/S. For
eg., expected proceeds from a lawsuit may meet
the definitions of both an asset and income as
well as the probability criterion for recognition;
however, if it is not possible for the claim to be
measured reliably, it should not be recognised as
an asset or as income; the existence of the claim,
however, would be disclosed in the notes,
explanatory material or supplementary schedules.

For a large population of receivables, however,
some degree of non-payment is normally
considered probable; hence an expense
representing the expected reduction in economic
benefits is recognised.
An item that, at a particular point in time, fails to
meet the recognition criteria may qualify for
recognition at a later date as a result of
subsequent circumstances or events.
An item that possesses essential characteristics of
an element but fails to meet the criteria for
recognition may nonetheless warrant disclosure in
notes, explanatory material or in supplementary
schedules.

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Recognition of Assets
An asset is recognised in the balance sheet when
(a) it is probable that future economic benefits will flow to the entity and

(b) the asset has a cost or value that can be measured reliably.
An asset is not recognised in the balance sheet when expenditure has been incurred for which it is
considered improbable that economic benefits will flow to the entity beyond the current accounting
period.
Instead such a transaction results in the recognition of an expense in I/S.

Recognition of Liabilities
A liability is recognised in the balance sheet when
(a) it is probable that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation and

(b) the amount at which the settlement will take place can be measured reliably.
In practice, obligations under contracts that are equally proportionately unperformed (for example,
liabilities for inventory ordered but not yet received) are generally not recognised as liabilities in F/Ss.
However, such obligations may meet the definition of liabilities and, provided the recognition criteria are
met in the particular circumstances, may qualify for recognition.
In such circumstances, recognition of liabilities entails recognition of related assets or expenses.
Recognition of Income
Income is recognised in the income statement when
→ an increase in future economic benefits related to an increase in an asset or a decrease of a
liability has arisen that can be measured reliably.
Recognition of income occurs simultaneously with the recognition of increases in assets or decreases in
liabilities
Recognition of Expenses
Expenses are recognised in the income statement when
→ a decrease in future economic benefits related to a decrease in an asset or an increase of a
liability has arisen that can be measured reliably.
Recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a
decrease in assets (for example, the accrual of employee entitlements or the depreciation of equipment).
Expenses are recognised in I/S
→ on the basis of a direct association between costs incurred and earning of specific items of
income.

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This process, commonly referred to as matching of costs with revenues, involves the simultaneous or
combined recognition of revenues and expenses that result directly and jointly from the same transactions
or other events
→ on the basis of systematic and rational allocation procedures when economic benefits are
expected to arise over several accounting periods and the association with income can only be
broadly or indirectly determined.
E.g. depreciation or amortisation
→ when an expenditure produces no future economic benefits or when, and to the extent that, future
economic benefits do not qualify, or cease to qualify, for recognition in B/s as an asset.

→ also in those cases when a liability is incurred without recognition of an asset, as when a
liability under a product warranty arises.
Measurement of elements of F/S

Historical Cost Current Cost NRV Present Value

Measurement is the process of determining monetary amounts at which elements of F/Ss are to be
recognised and carried in B/s and I/S. This involves selection of the particular basis of measurement.
Measurement basis most commonly adopted by entities in preparing their F/Ss is historical cost. This is
usually combined with other measurement bases. For e.g., inventories are usually carried at the lower of
cost and NRV, marketable securities may be carried at market value and pension liabilities are carried at
their PV. Furthermore, some entities use the current cost basis as a response to the inability of the
historical cost accounting model to deal with the effects of changing prices of non-monetary assets.
Concepts of capital and capital maintenance (CM)
Capital maintenance concept is concerned with how an entity defines the capital that it seeks to maintain.
It provides the point of reference by which profit is measured;
It is a pre-requisite for distinguishing between an entity’s return ON capital and its return OF capital;
Only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and
therefore as a return on capital.
P ( L ) = I – E (including CM adjustments, where appropriate) have been deducted from.
CM concept is inherent in profit measurement process comparing A, L & E of 2 different accounting
dates.
Principal difference between 2 concepts : Treatment of effects of changes in the prices of A & L of
entity.
Selection of basis under this concept is dependent on type of financial capital that entity is seeking to
maintain.

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 Financial Concept of Capital
Does not require use of a particular basis of
measurement
Adopted by most entities in preparing their F/S.
Under a financial concept of capital, such as
invested money or invested purchasing power,
capital is synonymous with NA or Equity of the
entity.
Adopted if primary concern is
→ Maintenance of nominal invested capital or
purchasing power of invested capital
Profit is earned only if
→ financial (or money) amount of NA at period
end exceeds the financial (or money) amount of
NA at period beginning,
after excluding any distributions to, and
contributions from, owners during the period.
Where capital is defined in terms of
( a ) nominal monetary units,
profit = ↑ in nominal money capital over the
period.
Thus, increases in prices of As held over the
period ( holding gains ), are, conceptually, profits.
They may not be recognised as such, however,
until the assets are disposed of in an exchange
transaction.
( b ) constant purchasing power units,
profit = ↑ in invested purchasing power over the
period.
Thus, only that part of ↑ in the prices of assets
that exceeds ↑ in the general level of prices is
regarded as profit.
Rest of ↑ is treated as a capital maintenance
adjustment and, hence, as part of equity.
Physical Concept of Capital
Requires adoption of Current Cost basis of
measurement
Under a physical concept of capital, such as
operating capability,
capital is regarded as productive capacity of entity
based on, for example, units of output per day.
→ Operating capability of the entity.
The concept chosen indicates goal to be attained
in determining profit.
Profit is earned only if
→ PPC (or operating capability) of the entity at
period end exceeds operating capability at period
beginning,
after excluding any distributions to, and
contributions from, owners during the period.
When capital is defined in terms of
physical productive capacity ( PPC ),
profit = ↑ in that capital over the period.
All price changes affecting A & L of the entity
are viewed as changes in the measurement of PPC
of the entity;
Hence, they are treated as capital maintenance
adjustments that are part of EQUITY and not as
profit.
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